In addition to commercial banks, other financial institutions, such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks borrow and lend in the federal funds market. (The 12 Federal Home Loan Banks were created by Congress to raise funds in financial markets and make loans to local financial institutions to enable them to make mortgage and other loans.) Unlike commercial banks, these other financial institutions that can borrow and lend in the federal funds market are not eligible to receive interest on deposits with the Federal Reserve.

a. An article by two Federal Reserve economists notes that “the Federal Home Loan Banks use the federal funds market to warehouse liquidity to meet unexpected borrowing demands from members. . . .” What are the implications of this observation for the possibility that the equilibrium federal funds rate might drop below the interest rate the Fed pays on reserve deposits?

b. If only banks could borrow and lend in the federal funds market, explain why the actual federal funds rate could not drop below the interest rate the Fed pays on reserve deposits.